Here’s a great chart from Goldman Sachs that I spied as a result of a tweet by finance blogger Conor Sen who is someone to follow on Twitter. It shows the divergence in US household debt-to-income ratios and debt servicing costs as interest rates have declined. In my view this divergence has significant implications.

Cycles in money and bank credit are familiar from centuries past. And yet, for perhaps a generation, the symptoms of this old virus were left untreated. That neglect allowed the infection to spread from the financial system to the real economy, with near-fatal consequences for both.

In many ways, this was an odd disease to have contracted. The symptoms should have been all too obvious from history. The interplay of bank money and credit and the wider economy has been pivotal to the mandate of central banks for centuries. For at least a century, that was recognised in the design of public policy frameworks. The management of bank money and credit was a clear public policy prerequisite for maintaining broader macroeconomic and social stability.

Two developments – one academic, one policy-related – appear to have been responsible for this surprising memory loss. The first was the emergence of micro-founded dynamic stochastic general equilibrium (DGSE) models in economics. Because these models were built on real-business-cycle foundations, financial factors (asset prices, money and credit) played distinctly second fiddle, if they played a role at all.

The second was an accompaying neglect for aggregate money and credit conditions in the construction of public policy frameworks. Inflation targeting assumed primacy as a monetary policy framework, with little role for commercial banks’ balance sheets as either an end or an intermediate objective. And regulation of financial firms was in many cases taken out of the hands of central banks and delegated to separate supervisory agencies with an institution-specific, non-monetary focus.

What Haldane is saying is that making policy choices for the real economy must take credit and debt levels into account, especially when thinking about the fragility of our financial system. This is exactly what William White and Stephen Roach have been saying in questioning central bank policy. White puts it this way:

From a Keynesian perspective, based essentially on a one period model of the determinants of aggregate demand, it seemed clearly appropriate to try to support the level of spending. After the recession of 2009, the economies of the AME’s seemed to be operating well below potential, and inflationary pressures remained subdued. Indeed, various authors used plausible versions of the Taylor rule to assert that the real policy rate required to reestablish a full employment equilibrium (and prevent deflation) was significantly negative. Such findings were used to justify the use of non standard monetary measures when nominal policy rates hit the ZLB.

There is, however, an alternative perspective that focuses on how such policies can also lead to unintended consequences over longer time periods. This strand of thought also goes back to the pre War period, when many business cycle theorists focused on the cumulative effects of bank‐created‐credit on the supply side of the economy. In particular, the Austrian school of thought, spearheaded by von Mises and Hayek, warned that credit driven expansions would eventually lead to a costly misallocation of real resources (“malinvestments”) that would end in crisis. Based on his experience during the Japanese crisis of the 1990’s, Koo (2003) pointed out that an overhang of corporate investment and corporate debt could also lead to the same result (a “balance sheet recession”).

The disease is a protracted balance-sheet recession that has turned a generation of America’s consumers into zombies – the economic walking dead. Think Japan, and its corporate zombies of the 1990’s. Just as they wrote the script for the first of Japan’s lost decades, their counterparts are now doing the same for the US economy.

Two bubbles – property and credit – enabled a decade of excessive consumption. Since their collapse in 2007, US households have understandably become fixated on repairing the damage. That means paying down debt and rebuilding savings, leaving consumer demand mired in protracted weakness.

Yet the treatment prescribed for this malady has compounded the problem. Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand.

The convoluted logic behind this strategy is quite disturbing – not only for the US, but also for the global economy. There is nothing cyclical about the lasting aftershocks of a balance-sheet recession that have now been evident for nearly five years. Indeed, balance-sheet repair has barely begun for US households.

I have made this the central theme of this blog since its name, Credit Writedowns, is supposed to evoke a sense that bank and household balance sheets are the determining factor in this crisis. But my sense here is that policy makers are still steeped in denial, in large part because of the efficacy of their efforts in creating a cyclical rebound, as the economy has responded to low interest rates. This is illustrated in the chart by the steep decline in debt service ratios. And note, I called this rebound fairly early and received a lot of flak for it, so I do recognise the policy successes here. What mainstream economists and policy makers see when they look at the Goldman chart is that cyclical falloff in debt service ratios. This focus uniquely on debt service costs with no regard to debt to income or debt to GDP levels – what I call “The debt servicing cost mentality” – is extremely dangerous. What I see – and what Roach seems to be pointing to – is the less steep falloff in debt to income ratios. And this makes sense because policy rates are at or near zero percent, meaning that the next recession will not witness such a large divergence in debt service cost and debt-to-incme ratios. For debt service ratios to recede in the next downturn, debt to income ratios must be reduced at the same rate, whether through lower debt from default and debt forgiveness or increased income. Likely, default will play the overwhelming role, at least initially.

As I outlined over two years ago, the origins of the next crisis are the simultaneous attempt for the public and private sector to deleverage simultaneously across a broad swathe of large industrialised countries. What we should anticipate – and what we have already seen in the euro zone – is failure and debt deflation because you must have massive defaults and debt forgiveness to effect simultaneous deleveraging in the public and private spheres. If and when the United States joins the party, that’s when the full ramifications of our policies will become evident.

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Author: Edward HarrisonEdward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

14 Comments

The exact same problems are evident here in the UK. I suspect that debt burdens here are still very high. The low debt servicing ratios has lead to UK real estate economists being bullish for real estate as “affordability” has never been better. As you said this is dependant on low interest rates. This mirrors the US. So while US real estate prices have fallen much more than the UK the high levels of debt to income mean that either further substantial falls are eventually going to happen, or that the US will morph into another Japan with twenty plus years of stagnation. The problem is that the US does not have the domestic savings of Japan or even Italy to allow them the time to de-lever over the next two decades. A crash is inevitable and it will be painful. All that has been achieved is to kick the can down the road to the next administration or possibly the one after.

The UK still has more real estate price falls to price in and bank losses on debt that will wipe out all the new capital that they have raised. UK private levels of debt were the highest in the world so our massive property bubble will eventually burst but be even more savage than the US.

If you do have massive defaults to alleviate the real debt burden and not the debt servicing ratio then you need to withdraw support from the banks. This is what has destroyed the capability of Ireland to balance its own books. As debts are defaulted on the banks will collapse but the mistake was to support them. Moral Hazard has been abandoned to the leverage of political cronyism. This will allow governments to nationalise the branch networks of the banks at minimal cost and allow a new banking system to restart without the problems that are present today.

Five years ago my prediction was for an L shaped recovery. ie none. In some respects I was right. Full time jobs are being replaced by part time jobs yet workers median income is falling. The fact that central banks have thrown everything at the problem surprised me, in that it worked. The UK has still not recovered to its previous highs but the collapse of real estate has also not happened. You were right and I was far too pessimistic. Ultimately I might still be right as each new wave of QE is less and less effective than the previous wave. So as the world economy slows down the UK and US will fall eventually into recession and it may become apparent again that the Emperor still has no clothes. It is still a matter of credit write downs that are needed before they rebuild the economy. That is not being allowed to happen. The issue is not that for every debtor there is a creditor. That ignores the fact that much of those “assets” where created by the banks out of thin air.

Isn’t Edward agreeing here though, i.e. QE has been effective in the first instance by making debt more serviceable. However debt serviceability improvements via reduce interest will be less of an option in future, i.e., any improvement in debt service ratio will have to come from improvements in the debt to income ratio.

In the UK QE has clearly helped with serviceability in the first instance. This combined with a very dysfunctional property market and prices have, to an extent, held up more than they have in US. However now the only route to improvements in serviceability is a reduction in debt to income. I presume there is a trade off between how much will need to be written down and how long (at distortingly low interest rates) those writedowns can be put off.

Yes the only solution is a reduction of debt to income. Though with UK incomes stagnant or falling that means that debts have to fall even faster, than straight forward repayment would allow. So unless you want a twenty year stagnation you need massive numbers of defaults to address the problem. The US is doing much better on this score. The ability of debtors to pay down the debt with squeezed incomes will mean an even weaker economy. Yet JP Morgan increased profits yesterday via reductions in loan provisions on its mortgage book. That might be very premature.

You are right that it is a matter of whether they can hold off write downs as low interest rates allow borrowers to rebuild their balance sheet. Though I suspect that most will never be able to rebuild their balance sheet in time. So many more foreclosures will eventually flow through and bank losses will climb.

I am a little confused as to what do people mean when they refer to the concept that supposes that households are “actively” rebuilding their balance sheets. Let me explain…

From everything I can tell, the modest reduction in the household debt-to-income balance sheet which has occurred has actually come from the limited amounts of writedowns that the banks have carried out. It has been shown for example that nearly all of the reduction in overall credit card debt has come from bank writedowns for example (vs. consumers actively paying down their balances). I suspect the same applies to most of the reduction in mortgage debt as well.

Therefore, granted, households by their own volition (rather through actions by external entities like writedowns) are no longer on a massive upwards trajectory of increasing their debt load. However, on the other hand, when you count out the actions of external parties, households haven’t really made much of a dent in reducing their debt loads by their own actions.

So, can you really say that households are really “rebuilding their balancesheets”? So while they might no longer be increasing their load, seems to me that they are more like keeping their balance sheets maintained at a fairly high level, rather than actively trying to “rebuild” (i.e. reduce) them.

Rebuilding balance household balance sheets can be a very slow process. It can be the reduction of debts through normal repayments or bankruptcy. if there are no debts the fear of problems resulting in additional savings especially with interest rates so low. It also depends on how much disposable income they have left. This is usually by a switching of expenditures from consumption to savings.

If you have a home worth $200 000 and debts of $300 000 you will have net worth of -$100 000 so if you go bankrupt you will wipe out that $100 000 overall liability, so your net worth will increase from negative $100 000 to zero. In simple terms it is rebuilding your balance sheet.

Low income families which in reality is 50% of the population will find it hard to pay down debt especially with the inflation in basic consumer goods which are under reported in CPI figures. I suspect that most of that rebuilding will come from bankruptcy eliminating the debts rather than actual repayments.
I suspect that the reality is that while some are unable or unwilling to borrow there will be many more who are struggling to pay down debt to avoid bankruptcy. So they will have this debt burden for many years and only once interest rates rise will they go bankrupt when the repayments are too much to cover.

I guess I am more “hung up” on the connotation of the word “rebuild”, which most I think would interpret to mean “actively paying down” but in reality most of the reduction has come not from paydowns but from writedowns. It gets even more confusing because the media often repeats the meme of “households are now paying down debt” where in fact paying down debt has been a very small component of the reduction in overall debt. Most of it has come from writedowns. When people hear that “folks are now paying down debt” they are likely to misinterpret the true state of households and their ability to survive certain changes in this economic environment.

To be frank most of the media are talking BS. The financial media are the worst. This is all to create a sense of recovery so that people spend again. They are trying to sell something. Be it advisory advise to investors and hedge funds or their fund to the public. Most economists appear to have little understanding of the real world, they cannot explain why the euro periphery is not growing when they are cutting as demanded. They assume that they are not doing it fast enough when that is not the problem. They look at a problem and learn the wrong things from the experience. Bernanke is a great example. He thinks that the Depression happened because they did not save the banks. So all the Fed actions have saved the banks but look at main street. It is still struggling. Unemployment is as high as during the Depression but because the banks are still surviving the economy will grow according to Bernanke. Yet it is going nowhere.

Most economists seem to have a blind spot to the real solutions. Primarily because they are Neo-classical/Monetarist supply siders. So even while the US and the UK have amongst the most flexible labour markets they blame regulation for strangling the economy.

I think if there is one way to describe what both you and Edward are saying is to simply say that central banks are using liquidity medicines to solve insolvency diseases. Like giving chemotherapy for a broken leg. The shame is that the media doesn’t call them on it.

My general comment here is that @rob is right that the CB’s are trying to paper over insolvency by providing enough liquidity to let time heal the wounds. They have to hope then that recovery is robust and long enough for this to occur. And it is going to occur by what Michael Pettis calls loss socialisation – through negative real interest rates and higher than anticipated inflation if possible.

This is exactly the same kind of scheme that the Fed and the US Treasury used with regulatory forbearance regarding the too big too fail banks. Ultimately, the goal is to allow business as usual with no n=major adjustments to the way our financial system operates. It’s not inconceivable that this could work. On a lesser scale it worked in the early 1990s. It also worked in the early 1990s in China. But the scale of loss socialisation this time is simply enormous.

Yes but I think that we have known this for four years. It has been extend and pretend for four years. Central Banks are trying to maintain status quo. You are 100% right there. They want the banks to rebuild their balance sheets should there be another crisis. The problem is as I see it is that debt levels are simply too high.

Even if they somehow manage to revive the bubble economy and lending again I think we all know that it will be close to bursting as some point. I do not see inflation as a problem unless the money printing gets into overdrive. I see deflation as the only outcome. Though I would dispute the definition of inflation after the bursting of a massive bubble. Only after the revaluation of assets should we consider stimulus.

As John Stuart Mill famously said, ““Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”
I believe this describes ths e current situation precisely. Quantitative easing is just the current method of bringing the vlue of cash money into line with its actual worth.

“Ultimately, the goal is to allow business as usual with no major
adjustments to the way our financial system operates. It’s not
inconceivable that this could work. On a lesser scale it worked in the
early 1990s. It also worked in the early 1990s in China. But the scale
of loss socialisation this time is simply enormous.”

The other two big “but”s of course are: Total debt to GDP ratio now more than 1.5 times greater than the early 90s and stubbornly anemic growth (sub-2% years post-crisis, with no sign of pick up). Hard to see this plan “working” given these persistent headwinds. Can it happen? Maybe, but I don’t think it’s likely.

Yes, this time it’s different – but central banks apparently don’t see it so, hence they prescribe the same old medicine.

Re: “Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand.”
This is giving the Federal Reserve for considerably more credit than I believe it deserves. While Roach merely believes that the Fed’s errant policies are based on a misreading of the current economic condition, I submit to you that the Fed understands the current situation perfectly and that their actions, far from being errant, are accomplishing their intended — but unstated — purpose with ruthless efficiency.